Blog Introduction & Bubbles

My blog is going to centre upon the bizarre ‘Uranium bubble of 2007’, a period in time which saw  uranium prices rise from a level around the $20 mark to incredible highs in the region of $135.

Before I explore this particular bubble in more depth I would first of all like to get a more general flavour for what an economic (or speculative, or market, or price, or financial) bubble actually is, how common they are and what the supposed causes of these seemingly evident drifts away from market efficiency are said to be.

So, what exactly is a bubble? Before answering this question it is important to recognize that bubbles are not confined to the price of a particular commodity such as uranium but that they can form in economies, business sectors, stock markets or even individual securities. An interesting list of some of the more bizarre and exotic bubbles which have come to pass can be found here.

The earliest recorded bubble occurred during the 17^th century in the Dutch Tulip market and is affectionately referred to as ‘Tulip Mania’. Put simply, a bubble is a situation where the price for a particular asset (business sector, economy, etc.) is significantly higher than its fundamental or intrinsic value. This period of overly-inflated prices is usually (but not always) followed by a sharp decline in prices and when this happens the bubble is said to have ‘burst’. Given their definition, it is clear that bubbles fly in the face of standard financial market theory which postulates that asset prices should tend towards their intrinsic values. An article by Buchanan (2008) entitled ‘Why Economic Theory is Out of Whack’ highlights this contradiction and discusses the US mortgage market bubble which triggered the recent financial crisis. The full article can be accessed here.

Economic bubbles are probably more common than supporters of market efficiency would like to admit. Beginning in 1630’s with the aforementioned ‘Tulip Mania’, economies around the world have experienced bubbles in a variety of different sectors. The 1720’s saw bubbles form in the stocks of South Sea Company and Mississippi Company, the 1840’s endured ‘Railway Mania’, and then we had the Florida land boom of the 1920’s. More recent bubbles have included the Dot-com bubble of the 1990’s and the 2007 Romanian property bubble.

With regards to what causes economic bubbles, a consensus has not yet been reached but it is worth mentioning some of the popular (possible) explanations. The first contender is excessive monetary liquidity in the market which can be caused by a combination of easy money and an expansionary monetary policy. This provides the financial system with an excess supply of money until a situation is reached where too much money is chasing too few assets and bubbles inevitably form.

The moral hazard problem played a considerable role in the US sub-prime mortgage market and is another possible cause of bubbles. It is the idea that an investor shielded from risk may behave differently given this protection than if he/she were fully exposed to the risk borne by investment.

Other psychological factors which are said to support the formation of bubbles are herd behaviour and greater fool theory. Herding relates to the idea that investors will buy or sell an asset in accordance with the current market trend, for example a strong upward trend will induce frantic buying and cause a bubble to form.  Greater fool theory is an unsupported (yet quite amusing) explanation which suggests that bubbles are driven by the behaviour of overly optimistic investors known as ‘fools’ who buy overvalued assets with a view to selling them to others, the ‘greater fools’ at a higher price.